The legal and regulatory framework governing Islamic finance and markets in Bahrain | Lexology

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Legislative and regulatory framework

i Legislative and regulatory regime

Persons wishing to undertake regulated Islamic banking services must be licensed by the CBB as an Islamic bank licensee. Regulated Islamic banking services consist of three determinant activities: (1) accepting shariah money placements or deposits; (2) managing shariah profit-sharing investment accounts; and (3) offering shariah financing contracts. If an institution has the requisite licence, it may be able to offer all three regulated activities alongside various supplementary activities. Islamic bank licensees must operate in compliance with shariah economic principles and only Islamic bank licensees may hold themselves out to be fully shariah-compliant institutions. Ultimately, it is the type of licence issued by the regulator that determines whether an institution is shariah-compliant.

Every individual Islamic bank in Bahrain has its own internal shariah board, which determines the shariah compliance of its products. In December 2018, there were 382 institutions and 98 retail banks registered in the banking sector, of which 21 were Islamic banks licensed by the CBB. The CBB does not interfere with this internal process but is usually very helpful and facilitates discussions about new ideas and concepts. The CBB must approve new products before they can be offered to customers. The banks also need to inform their customers of associated risks and any unusual product features if the capital is not protected. If the capital is protected then the banks must inform the customers that there is a chance that the actual return may be lower than the anticipated or projected return.

Islamic bank licensees are divided into two subcategories: Islamic retail banks and Islamic wholesale banks. Specific regulatory requirements may differ between these two subcategories where appropriate to address their risk profiles.

Islamic retail banks may undertake transactions in any currency, with both Bahraini residents and non-residents. To qualify as an Islamic retail bank, the activity of offering shariah financing contracts must account for a significant portion of the institution’s business. This is defined, broadly, as accounting for over 20 per cent of an institution’s assets.

Islamic wholesale banks may also undertake transactions without restriction when dealing with the government of Bahrain and its agencies, CBB bank licensees and non-residents. However, they may only undertake transactions denominated in Bahraini dinars or with a resident of the Kingdom of Bahrain if these transactions are to be wholesale in nature. Wholesale transactions are defined in terms of transaction size (broadly, 7 million dinars or more for the activities of accepting shariah money placements or deposits and offering shariah financing contracts, and US$100,000 or more for any of the other activities falling within the definition of regulated Islamic banking services). Islamic wholesale banks are allowed to transact in dinars (or any other currency) for any amount with the government of Bahrain, Bahrain public sector entities (as defined in the guidelines for completion of the Prudential Information Returns for Islamic Banks Form) and CBB bank licensees. Islamic wholesale banks may also transact in dinars for any amount (where required) to fund their normal operating expenses when investing for their own account in securities listed on a licensed exchange.

Islamic bank licensees are subject to certain licensing conditions. These licensing conditions are consistent with international good practice, such as the relevant Basel Committee and Islamic Financial Services Board standards.

Islamic bank licensees must satisfy the CBB that their controllers are suitable and pose no undue risks to the licensee. There are also certain procedures, as set out in Articles 52 to 56 of the Central Bank of Bahrain and the Financial Institutions Law (the CBB Law) on controllers. Licensees and their controllers must also observe the CBB’s capital markets requirements in respect of changes in holdings of shares of listed companies. There are differing requirements for locally incorporated licensees (Bahraini Islamic bank licensees) and branches of foreign banks (overseas Islamic bank licensees). Requirements for overseas Islamic bank licensees are less onerous than those for Bahraini Islamic bank licensees.

A licensee that carries on an activity such as dealing in shariah-compliant financial instruments as agent (i.e., buying, selling or subscribing for shariah-compliant financial instruments on behalf of a client) should not determine the terms of the transaction and should not use its own financial resources for the purpose of funding the transaction. This means that the licensee must act as an agent and must not have a say in the terms of the transaction. Such a licensee may, however, receive or hold assets in connection with the transaction in its capacity as agent of its client. The following are examples of activities that, when taken in isolation, are unlikely to be regarded as acting in the capacity of an agent:

  1. appointing professional advisers;
  2. preparing a prospectus or business plan other than in connection with the Regulatory and Supervisory Module on Issuing and Offering of Securities and Sharia Compliant Sukuk of 2013 (the OFS Module);
  3. identifying potential sources of funding;
  4. assisting investors, subscribers or borrowers to complete and submit application forms other than in connection with the OFS Module, the CBB Rulebook Volume 6 (Capital Markets) and the CBB Rulebook Volume 7 (Collective Investment Undertakings); or
  5. receiving application forms for processing or checking and onward transmission other than in connection with the OFS Module, the CBB Rulebook Volume 6 (Capital Markets) and the CBB Rulebook Volume 7 (Collective Investment Undertakings).

Islamic bank licensees must maintain a minimum daily cash reserve balance with the CBB, set as a ratio of their total non-bank dinar funds, whether placed by way of call or unrestricted investment accounts (or similar), as well as taken through the issuance of dinar-denominated Islamic investment certificates. The current required ratio is 5 per cent and may be varied by the CBB at its discretion.

Islamic bank licensees must arrange for their external auditor to confirm the accuracy of the data reported on the eligible accounts report for the deposits or unrestricted investment account protection funds.

ii Regulatory and supervisory authorities

Conventional banks and shariah-complaint banks (referred to collectively as licensees) are both regulated by the CBB; however, the rules for each differ. The accounting standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) are compulsory for all Islamic banks and for conventional banks if they are maintaining Islamic units.

The CBB’s supervision of licensees is a mixture of on-site assessment (including the quality of systems and controls, and of books and records) and off-site supervision (which focuses on the analysis of regulatory returns, as well as of audited financial statements and other relevant public information). The CBB strengthened its supervisory role by establishing a centralised Shariah Supervisory Board in 2015 and launching the shariah governance framework, which became effective in June 2018.

On-site examinations are undertaken by the CBB’s own examiners, as well as by experts appointed for the purpose by the CBB (such as accountants and actuaries). Off-site supervision also includes regular prudential meetings with licensees to review performance, strategy and compliance matters (such as capital adequacy, large exposures and liquidity).

For banks, a risk profiling system has been developed to underpin the above supervisory efforts, by providing a detailed framework for assessing the impact and risk profile of individual licensees and prioritising subsequent supervisory efforts. Work is under way to extend this profiling system to insurance companies.

Should a licensee fail to satisfy the CBB’s regulatory requirements, then the measures outlined in the enforcement modules of the applicable volumes of the rule book may be applied. Enforcement measures include formal warnings, directions (e.g., to cease or desist from an activity), formal requests for information, adverse fit and proper findings, financial penalties or investigations. Extreme violations of the CBB’s regulatory requirements may entail cancellation of a licence, putting into administration or criminal sanctions.

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